The Separation of Banking and Commerce: Is It Worth It?

One of the great outstanding issues in American finance, both generally and in particular during the ongoing debate on repealing the Glass-Steagall Act, is the separation of banking and commerce. Depending on how one reads American history, it has been a legal tenet or historical imperative throughout our history that American banks not be controlled by commercial firms, and that banks themselves not control commercial firms. While the reasons for the separation are worthy, our recent history seems to bring into significant question the wisdom, if not the practicality, of trying to preserve it.

The source of the concept that banking should be separate from commerce is muddled, though the current rationale has force. The present-day theory is that the credit function would be distorted if a bank were owned by a particular business company or had significant commercial investments. For example, a bank owned by General Motors might be required by its owner to adopt a policy to make more loans to buyers of GM automobiles than those who buy Fords, Chryslers, Volvos and others. Or a bank that held a sizable stake in GM might adopt such a policy on its own in order to strengthen GM and thereby protect or enhance the value of the stake. Prohibiting GM from controlling a bank, or a bank from owning GM stock, avoids this possibility and thereby, so goes the theory, protects the objectivity of the credit-granting process. This makes it more likely that small entrepreneurs will obtain sufficient bank credit that they can grow to the point at which they can compete with GM. The paradox of the separation is that banking has been intertwined with commerce for as long as banks have existed; indeed, lending to business companies and serving their needs for payment services (through deposits and funds transfers) and risk-reduction services (such as letters of credit) have been the prime activities of banks historically.

The immediate problem with preserving the separation of banking and commerce is that this issue is standing in the way of modernizing the United States' financial structure. The debate on repealing Glass-Steagall has metamorphosed into a wide-ranging reconsideration of the Bank Holding Company Act, which implements the banking-commerce separation. The reasons for the linkage of Glass-Steagall with banking-commerce separation are quite understandable. Securities firms for decades have been deeply involved in making investments in commercial firms, usually new firms that are believed to have significant growth potential. Those investments take the form of holdings of sizable percentages of voting stock. Such holdings are not permissible for bank holding companies, which are limited to five percent of any class of voting stock of a nonbanking company. Any securities firm that decides to acquire a bank becomes subject to the same limitation on such holdings, totally apart from Glass-Steagall's restrictions. This means that merchant banking investments would have to be severely restricted, which many securities firms appear to believe would extract a cost that would vitiate many of the benefits of controlling a bank. Indeed, such holdings are an important part of capital formation in this country. Providing the seed capital for a small private company and nursing it along to the point at which it can be sold to the public has been an extremely profitable line of business for securities firms, and many private companies themselves would not have the opportunity to grow without attracting such seed capital at birth.

Preserving the banking-commerce separation will also pose a huge, if not insuperable, barrier to financial reform on the more basic level of politics. Apart from the value of merchant banking to securities firms, the more significant political problem may be that the acquisition/consolidation game would be slanted in favor of the banks in the event that Glass-Steagall were repealed while retaining the banking-commerce barrier. Bank holding companies have some flexibility in structuring holdings in nonbanking companies in order to stay within the Bank Holding Company Act's restrictions; for example, they can hold nonvoting stock, as well as voting stock, in circumstances in which a large part of the value of the company invested in can be captured. A nonbank company, however, will not have this flexibility if it attempts to acquire a bank holding company. This would give bank holding companies an advantage over nonbanking companies if the shackles of Glass-Steagall were finally removed. Nonbanking companies that fear acquisition are generally unlikely to favor such a possibility; many will want to be the acquiror rather than the acquiree.

Acknowledging the political realities, legislation currently under consideration in Congress would permit a bank holding company to make merchant banking investments to a limited extent. In addition to merchant banking investments, the legislation would also permit a limited amount of commercial involvement by bank holding companies, which could engage in non-financial activities so long as no more than 15 percent of their revenue comes from those activities. Conversely, commercial companies would be allowed to control banks with less than $500 million in assets so long as banking revenues are no more than 15 percent of total revenue.

These restrictions on bank ownership by commercial companies are probably unworkable. Revenue percentage limitations are generally difficult to comply with, especially for an entire organization, because of fluctuations in revenues from various types of activities over time. Size limitations always pose the problem, in a perverse sense, of the company subject to the limitation being successful and thereby growing beyond it. In both cases, the main problem is that the limits themselves are artificial; they are not related to any business rationale. Over time, the pressures on the limits will face no principled opposition, since there was no principle for the particular revenue or size limit in the first place. This means that the hard issue should be addressed: Do we continue to need banking to be separated from commerce?

There are several general reasons cited in favor of the banking-commerce separation. One is that it prevents the creation and maintenance of commercial-financial conglomerates of great size and economic power; the German system, and the pre-war Japanese zaibatsu, are the usual examples of this. Another one, described above, is that it prevent banks from being swayed by their ownership by or of commercial firms when making decisions on loans to other commercial firms. A third is that it cushions the impact on banks of recession or depression in the commercial world. The Federal Reserve appears to cling tenaciously to the vitality of the third reason and to suggest the importance of the second, while populists generally hold to the first reason.

There are several reasons to question the continued vitality of these reasons. Concerns about size seem almost quaint today. The Chase, Chemical and Manufacturers Hanover organizations combined into one within the space of five years, and the combined organization is now the largest bank in the country. Similar consolidation is taking place in the securities and insurance industries. However, even those combinations are creating organizations that are relatively small in the global arena, where truly massive organizations dominate the global banking and securities markets. The American public's response to consolidation has been muted. All this may mean that the historical fear of bigness in the banking industry has faded away.

The second concern might appear more vital, especially when organizations trumpet the benefits of synergies among their components. However, it may be questioned whether banking and financial services in reality provide the types of benefits that commercial firms seem to desire. Several such experiments of the last two decades seem to show that it is much more difficult to profit from those benefits than might appear. If commercial firms cannot do so, then any concerns about a significant amount of acquisition may be overblown. On a more basic level it may be questioned whether concerns about distortions in the granting of credit are a significant threat. Commercial firms for decades have been permitted to own one thrift institution without being subject to the banking-commerce divide. Ford, Sears and other major commercial firms have done so over the years, to varying degrees of success. And one can validly wonder whether the fear about distorted bank lending is a historical holdover, dating from the days before Federal regulation of the securities markets, when the United States capital markets did not have the transparency of operation that exists today. The capital and money markets provide a far greater scope of activity for seekers of credit than did the financial markets of 60 years ago.

The major problem with permitting the intermingling of banking and commerce would be the design of a regulatory system to accommodate it. Currently the Federal Reserve has general supervisory authority over a bank holding company and all of its nonbank subsidiaries and regulates capital levels and permissible business activities, with the general purpose of assuring that the holding company does not get into such financial difficulty that it poses a threat to the bank. When a bank holding company is restricted to financial activities, the system makes some sense; the Federal Reserve is familiar with most such businesses and can discern the general financial outlook for the organization. With a significant non-financial component to the organization, this system becomes problematic. The simplest alternative may be to focus on the financial condition of the bank rather than that of the holding company. This approach would, of course, put pressure on the statutory safeguards against abuse of the bank's credit facilities by the rest of the organization. This has been addressed by the various reform proposals in a variety of ways, none of which has attracted consensus.

Even though it appears that loosening the constraints on the separation of banking and commerce may be workable, and may be necessary in order to get the modernization that is long overdue, such a change would be a major, if not radical, departure from the recent history of the American financial system. Developing the consensus that such a change requires will need a thorough consideration of the pro's and con's of separation commercial firms from banks.

*Bradley Sabel is a partner at Shearman & Sterling, concentrating on bank regulatory matters. After graduating from the Cornell Law School in 1975, he joined the Federal Reserve Bank of New York, where he served for eighteen years, eventually as Vice President and Counsel.